Chapter 14

Analyzing Financial Statements

LEARNING OBJECTIVES
1.

Explain the purpose of financial statement analysis.

Financial statement analysis is used retrospectively in evaluating past
performance for the identification of problem areas.
Financial statement analysis is used prospectively as well.
Used to predict future profitability.
Used to predict future cash flows.
Informativeness of financial ratios greatly improved by comparisons to a
reference point.
Compare to past values.
Compare to values for other firms in same industry.

2.

Understand the relationships between financial statement numbers and use

ratios in analyzing and describing a companys performance.
Financial ratios result from the relationship between two financial statement
numbers.
Common ratios are:
Debt ratio,
Current ratio,
Return on sales,
Asset turnover,
Return on equity, and
Price-earnings ratio.

3.

Use common-size financial statements to perform comparison of financial

statements across years and between companies.
Common-size statements are created by dividing all financial statement
amounts for a given year by sales for that year.
Common-size income statements reveal the number of pennies of each
expense for each dollar of sales.
The asset section of a common-size balance sheet reveals how many
pennies of each asset are needed to generate each dollar of sales.

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Chapter 14

4.

5.

Profitability: return on sales is calculated as net income divided by sales and

is interpreted as the number of pennies of profit generated from each dollar
of sales.
Efficiency: asset turnover is calculated as sales divided by assets and is
interpreted as the number of dollars of sales generated from each dollar of
assets.
Leverage: assets-to-equity ratio is calculated as assets divided by equity and
is interpreted as the number of dollars of assets a company is able to acquire
for each dollar invested by stockholders.

Conduct a focused examination of a companys efficiency by using asset

specific ratios.
Efficiency of collections-Accounts receivable turnover.
Efficiency of selling inventory-Inventory turnover.
Efficiency of using fixed assets-Fixed asset turnover.
Efficiency of total assets-Asset turnover.

6. Determine the degree of a companys financial leverage and its ability to

repay loans using debt-related financial ratios.
Leverage of equity-Assets to equity.
Leverage of debt-Debt to equity.
Ability to meet required loan payments-Times interest earned.
7.

Use cash flow information to evaluate cash flow ratios.

Because the statement of cash flows is a relatively recent requirement
compared to other financial statements, ratios based on it are still in the early
stages of development and their use and acceptance is growing.
Cash flow ratios complement accrual based ratios to help provide a complete
picture of performance.
The ratio of cash flow to net income highlights when there are large
differences between cash from operations and net income.
The cash flow adequacy ratio demonstrates the ability of a company to
finance its capital expansion using cash generated from operations.

8.

Understand the limitations of financial statement analysis.

One must be careful in predicting a companys future by relying solely on the
quantitative data presented in financial statements.
Regarding the use of financial statement data for analyses, one needs to be
careful to:
Make adjustments when comparing firms for any differences in underlying
accounting practices which may exist.
Temper any decisions about a companys future, based on historical
performance as reflected in financial statements, by referencing any

2011 Cengage Learning. All Rights Reserved. This edition is intended for use outside of the U.S. only, with content that may be different from the
U.S. Edition. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part.

Chapter 14

additional information about future expectations that may currently be

available.

REVIEW OUTLINE
I.

THE NEED FOR FINANCIAL STATEMENT ANALYSIS

A. Raw financial statement numbers by themselves dont tell much of a story.
B. Financial Statement Analysis
1. Examines the relationships among financial statement numbers and the
trends in those numbers over time.
2. Diagnosticevaluates the companys performance with an eye toward
identifying problem areas.
3. Prognosticexamines the past performance of a company to predict how
it will do in the future.
4. Financial ratios.
a. Show relationships between financial statement amounts.
b. Many ratios exist, and each ratio sheds light on a different aspect of a
companys health.
c. Ratios generally dont directly provide all the answers, but they do
act as signals or flags to decision makers as to where to investigate
further in more detail.
d. For a ratio to be of greatest use, it needs to be benchmarked against
past amounts or against the value of the ratio for other firms in the
same industry.

II.

W IDELY USED FINANCIAL RATIOS

A. Debt Ratio
1. Measure of leverageextent to which a company has borrowed money to
leverage the owners investments.
2. Total liabilities Total assets.
3. General rule of thumb: should be around 50%, yet varies from industry to
industry.
B. Current (or Working Capital) Ratio
1. Measure of liquidity: a comparison of the current assets (cash
receivables, and inventory) to the current liabilities.
2. Total current assets Total current liabilities.
3. Historically, a current ratio below 2.0 suggests liquidity problems.

2011 Cengage Learning. All Rights Reserved. This edition is intended for use outside of the U.S. only, with content that may be different from the
U.S. Edition. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part.

Chapter 14

C.

D.

E.

F.

III.

4. Some loans impose a minimum current ratio restriction to force the

borrower to maintain its liquidity.
Return on Sales
1. Measure of the amount of profit earned per dollar of sales.
2. Net income Sales.
3. Should either be compared to company's period performance or against
others within the same industry (or industry average) since what is a
"normal" ROS varies between industries.
Asset Turnover
1. Measure of company efficiency (asset utilization).
2. Sales Total assets.
3. Generally, the higher the asset turnover ratio, the more efficiently the
company is using its assets to generate sales.
Return on Equity
1. Fundamental overall measure of performanceprofit earned per dollar of
owner investment.
2. Net income Owners equity.
3. Good ROEs typically run between 15% and 25%.
Price-Earnings Ratio
1. Measures the relationship between the market value of a company and its
current earnings.
2. Market value of shares net income (alternatively on a per share basis,
market price per share earnings per share).
3. In the United States, PE ratios typically run between 5 and 30.
4. High PE ratios are associated with companies that investors believe have
strong growth potential.
5. Note that the PE ratio is a bit unique in that only one, rather than both, of
its components is a financial statement number.

COMMON-SIZE FINANCIAL STATEMENTS

A. Should be the first step in any comprehensive financial statement analysis.
B. Helps eliminate comparability problems that otherwise exist due to
differences in the absolute size/scale of financial statement amounts through
time and across firms.
C. Divide all financial statement numbers by sales for that year, with all numbers
then being reported as a percentage of sales.
D. For a common-size balance sheet, the asset section can be used to
determine how efficiently the company is using its assets.

IV.

MORE EFFICIENCY RATIOS

2011 Cengage Learning. All Rights Reserved. This edition is intended for use outside of the U.S. only, with content that may be different from the
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Chapter 14

A. Accounts receivable efficiency

1. The more times accounts receivable turns over the more frequent the
cash collections.
2. Dividing the answer of the accounts receivable turnover into 365
converts this into number of days it takes to collect receivables.
B. Inventory efficiency
1. This measures the number of times inventory is turned over.
2. The number of days sales in inventory is calculated by dividing the
answer in B. 1. by 365.
C. Property, Plant, and Equipment Efficiency
1. This measures how efficient the property, plant and equipment
help in producing sales.
2. It is calculated by dividing average fixed assets into sales. The
higher the resulting answer indicates the company is more
efficient in use of its fixed assets.
V.

MORE LEVERAGE RATIOS

A. Debt to equity ratio
1. Dividing total liabilities by total stockholders equity calculates the
leverage of debt to equity.
2. Students often confuse this ratio with the debt ratio and assets-to- equity
ratio. All three represent the same thingthe relationship between the
amount of a companys borrowing and the amount of a companys
stockholder investment.
B. Times Interest Earned
1. Indicator of the company to meet the required interest payments.
2. To calculate this ratio divide income before interest and taxes
by annual interest expense.

VI.

CASH FLOW RATIOS

A. Because of the newness of the statement of cash flows relative to other
financial statements, cash flow related information is not yet ingrained in the
analytical tradition.
B. Cash flow related information is particularly useful in those situations in
which net income does not give an accurate picture of the economic
performance of a company, such as when:
1. Large noncash expenses exist (i.e., things may not be as bad as net
income portrays).

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Chapter 14

2. Rapid growth exists (i.e., things may not be as good as net income
portrays)
3. Window Dressing may be present (i.e., cash flow related information is a
good reality check any time there are specific events occurring which
potentially may be distorting accrual results, such as when a company is
applying for a loan or initiating an IPO).
C. Cash flow to net income
1. Relates cash flow from operations to net income: cash from operations
net income
2. Reflects the extent to which accrual accounting assumptions and
adjustments have been included in computing net income.
3. In general, the ratio will have a value greater than one due to the
existence of noncash expenses which reduce net income but that have no
impact on cash flow.
4. For a given company, the ratio should remain fairly stable from year to
year.
D. Cash flow adequacy
1. A cash cow is a business that generates enough cash from its
operations to pay for investments in fixed assets and still have some
remaining with which to repay creditors and/or distribute to investors.
2. Ratio defined as: cash from operations expenditures for fixed asset
additions and acquisitions of new businesses.
VII.

POTENTIAL PITFALLS
A. Financial statements dont contain all information there is a lot of decisionrelevant information outside the statements. Examples:
1. Market values of many assets are not reflected in the statements
2. Some assets of great worth to a company are not even reported at all
(i.e., brand recognition, customer loyalty, etc.)
3. There are nonquantitative factors to consider as well.
B. Lack of comparability, stemming from:
1. Dissimilar classification schemes for reporting essentially the same thing
(i.e., a particular expense may be reported as part of one line item on the
financial statements of company A but be reported as part of a different
line item for company B).
2. Conglomerates large companies in multiple lines of business across
different industries.
a. Companies with a much narrower focus will be comparing apples to
oranges if trying to benchmark themselves against such diversified
businesses.
b. Comparisons to only a segment of a conglomerate may be much more
relevant in such cases.

2011 Cengage Learning. All Rights Reserved. This edition is intended for use outside of the U.S. only, with content that may be different from the
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Chapter 14

C. Searching for the smoking gun: if approaching every financial analysis as a

case to be solved, wherein there is only one significant issue of main
concern to detect no doubt, you may overlook indications of a collection of
less spectacular problems.
D. Anchoring, adjustment, and timeliness: must be careful to not let past
performance totally dictate expectations about future performance, especially
in light of significant relevant data currently available which should also help
shape those future expectations.

2011 Cengage Learning. All Rights Reserved. This edition is intended for use outside of the U.S. only, with content that may be different from the
U.S. Edition. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part.